Friday, April 20, 2012

Hedge Fund Intelligence is out with an interesting report on hedge fund assets. In it, they find that overall assets increased in 2011. Despite the fact that the median performance of hedge funds in 2011 was -2.01%, the industry still saw net inflows.

At $2.059 trillion in assets, hedge funds still have yet to re-conquer the peak in assets reached in 2007 of over $2.5 trillion.

According to the release, "The US market remains very much the top location for the world's biggest hedge fund firms. There are currently 230 firms that manage hedge fund assets of $1 billion or more from the US."

GMO's Jeremy Grantham is out with his latest quarterly letter. In it, he talks about how to bet against bull market irrationality. He also touches on the tension between protecting your job or your clients' money. He also says that investment managers, in order to not lose their jobs, must "never, ever be wrong on your own."

On how most investors prevent this, Grantham goes on to write:

"Professional investors pay ruth­less atten­tion to what other investors in gen­eral are doing. The great major­ity 'go with the flow,' either com­pletely or par­tially. This cre­ates herd­ing, or momen­tum, which dri­ves prices far above or far below fair price."

Herding in the markets is by no means a new phenomenon. Legendary investor Michael Steinhardt last year said that there's more herding in hedge funds than ever.

Grantham then goes on to re-phrase the oft-quoted Keynes reference of "the market can stay irrational longer than the investor can stay solvent" to an amended version that ends with "longer than the client can stay patient."

How to Survive Betting Against Bull Market Irrationality

Grantham lays out 3 main ways to do so:

1. Invest with a margin of safety: This, of course, is one of the principles by which Seth Klarman and many other value investors invest. The last two days we've highlighted notes from Seth Klarman's Margin of Safety.

2. Stay reasonably diversified: For a retail investor, this can make sense. However, we'd imagine that numerous hedge funds would disagree with this statement.

Many long/short managers often run portfolios of around 20 long positions and 30-40 short positions. Their argument would be that in lieu of diversification as a means to protect from downside, they've outright hedged by shorting. But then again, it all comes down to Grantham's definition of just how diversified 'reasonably diversified' is.

3. Never use leverage: Leverage has been the demise of many investors, so this is prudent advice. While some hedge funds employ leverage, the ones who do so successfully seemingly keep it to low levels. It's when you're leveraged 30:1 (or whatever Lehman Brothers was at) that problems arise.

Thursday, April 19, 2012

Goldman Sachs' Investment Strategy Group recently reviewed four areas they're watching in regards to the markets and economy. In a research note, they address:

1. The current US trajectory: While they do not project growth above the natural trend, they do believe the country is on a sustainable, slow & steady trajectory.

2. Equity valuations: Goldman uses numerous metrics to measure valuation such as 10-year cash flow, price to book, and price to trend earnings. Using a combination of those, they believe equities are fairly valued. They outline two key questions: are margins at risk of declining? And do earnings have to follow suit and decline as well? They feel that margins will be sustained.

3. Geopolitical and other risks: They highlight Middle East tension, renewed pressures in the European periphery, as well as a hard landing in China as key risks. On the last issue, we've posted up Dan Arbess versus Jim Chanos on whether China is a bubble or bonanza. Goldman outlines a combination of these risks accounting for a 25% downside probability in US markets.

4. The merits - or lack thereof - of the old adage, "Sell in May, and go away": Goldman's team identified statistically significant weakness in the month of September. But historically, they point to positive returns in May through August. The main takeaway here is that if the market is down in September, it has typically gone down a lot. That said, they found no evidence to support a consistent "sell in May and go away" investment strategy.

Goldman's Investment Conclusion

Their Investment Strategy Group writes,

"While the economic backdrop, neutral valuations, and moderate geopolitical and economic risks favor equities in our opinion, we also recognize that investing in equities entails volatility. As an asset class with 15% annual volatility, it is typical for equities to decline by 5% or more about 3 times a year and 10% or more about once a year, on average. So to capture the upward trend in equities, an investor has to tolerate the frequent downdrafts. The latest non-farm payroll and heightened concerns about peripheral Europe might well result in one of these downdrafts; in fact, our very short-term momentum signals have turned negative. But as investors - rather than traders - we recommend staying long equities. For those who are underinvested, we recommend using downdrafts as opportunities to build equity positions."

Bill Ackman's Pershing Square Capital just filed a form 4 with the SEC regarding a total return swap on J.C. Penney (JCP). On April 13th, they disposed of a total return swap with a conversion/exercise price of $34.15 that represented 602,600 underlying shares.

Due to the terms of the swap with the counterparty, Pershing netted the difference between the expiration price of $34.15 and the $29.29 reference price as established by the swap. Hedge funds often utilize total return swaps to ramp up leverage. We've previously highlighted when Pershing bought total return swaps late last year.

Here's the fine print from the filing:

"Under the terms of the cash-settled total return swap (i) Pershing Square International was obligated to pay to the bank counterparty any negative price performance under $29.29 per share for each of the 602,600 notional number of shares of Common Stock subject to the swap as of the expiration date, plus interest at the rates set forth in the contract, and

(ii) the bank counterparty was obligated to pay to Pershing Square International any positive price performance above $29.29 per share for each of the 602,000 notional shares of Common Stock subject to the swap as of the expiration date. Any dividends received by the counterparty on such notional shares of Common Stock during the term of the swap were to be paid to Pershing Square International as of the expiration date of the swap. At the time of the expiration of the cash-settled total return swap, the price of the reference security was $34.15 per share. All balances have been settled in cash.

As to why the swap was disposed, the fine print reads:

"The swap terminated in accordance with its own terms on April 13, 2012 without action on the part of the Reporting Persons, and, on such date, the Reporting Persons were unable to enter into replacement positions due to regulatory restrictions and the issuer's compliance restrictions. The Reporting Persons may in the future replace the expired swap, subject to any regulatory restrictions, the issuer's compliance restrictions, and any market conditions that may exist at that time."

John Paulson's group of hedge funds at Paulson & Co just filed a Form 4 with the SEC regarding its position in Delphi Automotive (DLPH). We previously highlighted how Paulson was selling DLPH and he's at it again.

Per the filing, Paulson & Co was out selling DLPH shares on April 16th through 18th. In total, all their various entities sold just over 3 million shares.

A few months back, Charlie Rose interviewed Baupost Group's legendary investor Seth Klarman. Just yesterday, we posted up notes from Seth Klarman's Margin of Safety so we figured this was a very appropriate follow up.

The video interview starts with talk about his nonprofit "Facing History" for the first 18 minutes or so. After that, they shift topics to Klarman's book, Margin of Safety.

One interesting tidbit from the conversation is when Klarman contrasted his investing style to that of Warren Buffett's. Baupost's leading man says that he buys "cigar butts" at cheap prices. Warren Buffett used to also do this. The difference between the two legends is that Klarman stayed focused on cigar butts while Buffett's process morphed into buying great companies at great prices and then into paying so-so prices for great companies.

Appearances and interviews by Klarman in public are rare, so needless to say this is a must-watch. Embedded below is Charlie Rose's interview with Seth Klarman:

Wednesday, April 18, 2012

Thanks to a reader for sending us the following notes from Seth Klarman's famous book, Margin of Safety. Written by Ronald Redfield, these notes provide a great summary of Klarman's book for those of you who don't want to pay $1,000 for a now out-of-print copy.

Why should you care about this? Well, for those of you who are unfamiliar, Klarman's Baupost Group is one of the top 10 hedge funds by net gains since inception. And since numbers do the talking in the investing world, it's time to pull up a chair and learn from the best.

Redfield singles out prudent quotes from Klarman such as this gem on risk:

"Targeting investment returns leads investors to focus on potential upside rather on downside risk ... rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk."

And by focusing on risk, Klarman of course hints that investors should seek a margin of safety in their investments. He goes on to specifically address this topic, writing:

"A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

Redfield points out that Klarman says investors can battle risk via diversification, hedging, and investing with a margin of safety.

Klarman also touches on other tricky aspects of investing, such as forced selling. He writes, "The trick of successful investors is to sell when they want to, not when they have to. Investors who may need to sell should not own marketable securities other than U.S. Treasury Bills."

John Burbank of Passport Capital has echoed this via his timeless quote: "cash is most valuable when others don't have it." This refers to cash's utility as a hedge during a downturn as well as its ability to fund opportunistic purchases while others are forced to do otherwise.

Continuing the series of educational articles on Market Folly, today we present Lectures on Financial Economics by Antonio Mele. Published in March 2012, it comes from the University of Lugano and the Swiss Finance Institute.

In the publication, Mele addresses:

Part I "Foundations": Fundamental tools of analysis such as classical portfolio selection, dynamic consumption- and production- based asset pricing.

Tuesday, April 17, 2012

Burnham Banks has penned an interesting comparison of conditional probabilities between hedge fund returns and equity market returns on a monthly basis. For this study, he used the MSCI World Equity Index and the HFRI Hedge Fund Index.

He finds that:

- Since January 1997: when equities are down, a hedge fund's chances of losing money are 69% and when equities are up, a hedge fund's chances of losing money are 7%.

- Since January 2008: when equities are down, a hedge fund's chances of losing money are 81% and when equities are up, a hedge fund's chances of losing money are 4%.

It should obviously be noted that the second date range is skewed by the financial crisis as large equity declines saw large drawdowns at various hedge funds. At the same time, snap-back rallies in 2009 and 2010 also influenced things.

The numbers are intriguing, though, when you consider that in 2011, many hedge funds lagged their respective indices. While many attributed this to having inappropriate gross/net exposures, it could have also just merely come down to market timing as the Wall Street adage, 'sell in May and go away' held true and the market declined precipitously in the second half of the year.

One thing to consider is that the article says "forget about correlations." And on that issue, we'd highly recommend reading excerpts from Maverick Capital's investor letter. In it, founder Lee Ainslie addresses correlation, writing:

"Last year intra-stock correlations reached all-time highs, surpassing even the levels seen in 1929 and 2008. In other words, stocks moved in tandem with one another to a degree never before seen and were less responsive to idiosyncratic risks, such as fundamental factors, than ever before. Such an environment is clearly challenging for long/short investors who rely upon stock prices being responsive to fundamental differences among companies."

So when viewing the conditional probabilities above, you certainly have to keep in mind that the narrow, more recent date range includes two years (2008 and 2011) where correlations reached extremes and certainly affected hedge fund performance. You can read the article here.

Market strategist Jeff Saut is out with his weekly investment strategy entitled, 'Be Conservative, Not Conventional.' In it, he summons advice from Benjamin Graham, telling investors to focus on risk rather than returns.

"The two most definitive studies ever on long-term returns, the Ibbotson/Sinquefield and Fisher/Lorie studies, both point to average annual returns for stocks of 9% plus per year going back to the mid-1920s. So 15% to 20% per year is really 66% to 100% better than the market as a whole. That's tough but doable. Consistency is the key.

It's the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%."

With this quotation and the recent market decline, it's quite obvious that Saut is trying to get investors focus on the 'risk' aspect of the equation, rather than the oft-lusted 'reward' side.

Saut also mentions technical analysis and levels on the S&P 500 he is watching. While he saw minor support around 1360-65, his hunch was a break below 1375 brings into play the 1320-1340 level as next support (the market currently trades around 1370).

He believes that this, coupled with a break below the 50-day moving average, warrants a cautious approach. The strategist points to shares of Apple (AAPL) as a tell. It's often thought that market leaders such as AAPL are the last to fall in declines... and AAPL has done just that recently.

A new position by Seth Klarman's Baupost Group was recently revealed. However, instead of the traditional methods whereby a hedge fund discloses the position to a regulatory body (such as the SEC), this position was actually revealed by a company.

In Vivendi's (EPA:VIV) 2011 annual report, they disclose that Baupost Group owned 25.5 million shares as of February 29th, 2012. At that time, it was worth overt $400 million. This equates to around a 2.04% ownership stake in the company.

That would have made it Baupost's largest equity position (that had been disclosed) at the time. (Bear in mind that Baupost only allocates a portion of its portfolio to equities). Since then, though, shares of VIV have declined and their stake is now worth considerably less.

This isn't the only major media company the hedge fund has a stake in. Our Hedge Fund Wisdom newsletter subscribers have long known that Baupost Group owns a stake in News Corp (NWSA) as well.

Per Google Finance, Vivendi is "a France-based company engaged in telecommunications services and media entertainment. The Company operates six core subsidiaries: Activision Blizzard, a 60%-owned publisher of online and console games; Universal Music Group, a 100%-owned recorded music company; SFR, a 100%-owned French telecommunications operator; Maroc Telecom Group, a 53%-owned mobile and fixed-line and Internet operator in Morocco, active also in Burkina Faso, Gabon, Mauritania and Mali; GVT, a 100%-owned telecommunications operator in Brazil; and Groupe Canal+, a 100% subsidiary, which offers premium and theme channel distribution and programming in France."

Monday, April 16, 2012

Ken Griffin's hedge fund firm Citadel Investment Group has filed a 13G with the SEC concerning its position in The Children's Place Retail Stores (PLCE).

Per the filing, Citadel now owns 4.7% of the company with 1,152,935 shares. They only owned 417 shares at the end of 2011, so they've certainly been out buying shares in size. The disclosure was filed due to trading activity on April 9th.

Per Google Finance, Children's Place is "is a pure-play children's specialty apparel retailer in North America. The Children's Place provides apparel, accessories and shoes for children from newborn to 10 years old. It operates in two segments: the Children's Place United States and the Children's Place Canada. The Company designs, contracts to manufacture and sells merchandise under The Children's Place brand name."

Per the first filing, SAC Capital has disclosed a 5.6% ownership stake in MedAssets (MDAS) with 3,238,369 shares. This marks an increase of 10,814% in their position size since the end of 2011 as they only held a tiny position then. The new disclosure was made due to trading activity on April 5th.

Per Google Finance, MedAssets "provides technology-enabled products and services. The Company’s technology-enabled solutions are delivered primarily through company-hosted software, or software as a service (SaaS) or Web-based applications, supported by implementation, consulting and outsourced services and consulting, as well as enterprise-wide sales and customer management and support."

OCZ Technology (OCZ)

Cohen's firm also filed a 13G on OCZ where they revealed a 5.5% ownership stake in the company with 3,711,431 shares. This marks a 71% increase in their position size since the end of 2011.

We originally detailed when SAC built its OCZ stake back in the summer of last year. Their latest disclosure was due to trading activity on April 5th.

Per Google Finance, OCZ is "a provider of high performance solid state drives (SSDs) and memory modules for computing devices and systems. In addition to its SSD and Memory Module product lines, the Company also designs, develops, manufactures and distributes other high performance components for computing devices and systems, including thermal management solutions and alternating current/direct current (AC/DC) switching power supply units (PSUs)."

For more portfolio moves from this hedge fund, click here to see our article yesterday on what stock SAC bought more of.

The stock of the week this time around is WellPoint (WLP) and the analysis below takes a look at some potential reasons as to why Steve Romick of FPA Crescent might like the company. Last week we featured: why David Einhorn owns Dell.

Hedge funds as a group have struggled performance-wise in recent years. However, there is one sector which has treated them very well: the HMO's. In 2010, at the height of uncertainty surrounding Obamacare, many hedge funds took positions in HMOs such as UnitedHealth (UNH), Cigna (CI) and WellPoint (WLP).

Since then, most of the stocks in the group are up by 50%, with some nearly doubling. Even after this large rise, many stocks in the the group are still cheap. Currently, Farallon Capital Management and Steve Romick of FPA Crescent hold positions in WellPoint.

WellPoint currently trades at $69.25 a share. They are expected to earn $7.70 in the current year and $8.50 next year. WellPoint is planning on repurchasing $2.5 billion worth of their own shares this year, which amounts to nearly 11% of the shares outstanding at the current price.

The most often cited reason for this bargain basement price is the continued uncertainty surrounding Obamacare. While Obamacare will lead to more customers, there is uncertainty regarding many of the new laws (specifically the mandate that requires them to accept customers at their quoted price, even if they are already sick).

The stock has underperformed its peers in the HMO sector recently as earnings disappointed last quarter. Wellpoint mispriced a large policy in California, which they have since terminated. As a result, Wellpoint trades at a discount to the group, even though it is the second largest HMO in a business where scale matters.

What I Like:

- The valuation of 8.15 times 2013 earnings estimates is extremely attractive assuming estimates are anywhere near accurate.

- Management has an excellent track record of returning cash to shareholders and have said they will return $2.5 billion this year via share repurchases. The share repurchase should put a floor under the stock as there will constantly be a large buyer in the market.

- There is little to no European risk in the business and economic sensitivity is minimal.

- Management recently reiterated their intent to repurchase $2.5 billion worth of shares this year, which likely means that this year is less than a disaster.

What I Don't Like:

- Low health care utilization has helped the earnings of HMOs in recent years. This trend is likely to end at some point.

- Obamacare is a wildcard as it can help or hurt earnings. While there will be more customers there will also be new regulations. This large change is a big uncertainty, which investors don't like.

- A decade ago, HMO industry profits plunged as companies fought for market share. Since then, the industry has consolidated and become more rational. However, there is still the risk that the industry is more cyclical than most believe.

There are numerous risks in WellPoint, such as Obamacare and the risk that margins for the industry contract. However, at a little over 8 times next year's earnings there is a large margin of safety in WLP's stock price. Even if estimates are off by 20% the stock is still cheap. The nice part of the business is that it is insulated from Europe and has little economic sensitivity. As a result, I am long WellPoint.

Steve Cohen's hedge fund SAC Capital filed a 13G with the SEC regarding its position in Amarin (AMRN). Per the filing, the firm now owns 5.3% of the company with 7,216,209 shares.

This marks a 33% increase in their position size since the last disclosure. This is the second subsequent purchase of AMRN shares by the hedge fund in the past month or so. The latest disclosure was made due to trading activity on April 3rd.

Per Google Finance, Amarin is "a clinical-stage biopharmaceutical company focused on developing improved treatments for cardiovascular disease. The Company’s development programs capitalize in the field of lipid science and the therapeutic benefits of essential fatty acids in cardiovascular disease. It is focusing its efforts on its candidate, AMR101, a prescription grade Omega-3 fatty acid, comprising not less than 96% ultra pure ethyl ester of eicosapentaenoic acid (ethyl-EPA)."

Wilmot Harkey's hedge fund Nantahala Capital Management recently filed a slew of 13G's with the SEC. We recently also disclosed their new stake in Scientific Learning.

From the new batch of filings, Harkey's firm has revealed a brand new position in Regional Management (RM). They now own 5.275% of the company with 649,465 shares and the filing was made due to portfolio activity on April 5th.

Second, Nantahala Capital has also revealed a new stake in Pinnacle Airlines (PNCL now trading as PNCLQ). The company recently filed for bankruptcy protection to tackle its debt and costs. Shares were delisted due to failure to satisfy a continued listing rule and now trade on the pink sheets.

Harkey's fund disclosed a 9.825% ownership stake in Pinnacle with 1,879,232 shares. The 13G was filed with the SEC due to trading activity on April 4th. Just last week we highlighted how Mohnish Pabrai sold Pinnacle shares.

Per Google Finance, Pinnacle Airlines is "an airline holding company based in Memphis, Tennessee. It is a parent company of three wholly owned subsidiaries: Pinnacle Airlines, Inc., Colgan Air, Inc. and Mesaba Airlines."

About Nantahala Capital

The hedge fund runs a fundamental strategy with a primary focus on small cap stocks. They have a market-neutral discipline as they take a balanced risk management approach (their long book resembles their short book). They focus on expected return on capital. Though we haven't seen more recent numbers, as of mid-year 2010, Nantahala had seen a 19.2% net annualized return over 5 years.

Wil Harkey founded the firm in 2004. Prior to founding Nantahala, he worked at Sagamore Hill Capital where he focused on capital structure arbitrage. He earned his BA in Mathematics and Economics from Williams College. Dan Mack joined as co-portfolio manager in 2007. Prior to that, he also worked at Sagamore Hill Capital focusing on event-driven and convertible arbitrage strategies. He earned is BS in Economics and a BSE in Computer Science and Engineering from the University of Pennsylvania.

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